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New formulations of ambiguous volatility with an application to optimal dynamic contracting

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  • Hansen, Peter G.

Abstract

I introduce novel preference formulations which capture aversion to ambiguity about unknown and potentially time-varying volatility. I compare these preferences with Gilboa and Schmeidler's maxmin expected utility as well as variational formulations of ambiguity aversion. The impact of ambiguity aversion is illustrated in a simple static model of portfolio choice, as well as a dynamic model of optimal contracting under repeated moral hazard. Implications for investor beliefs, optimal design of corporate securities, and asset pricing are explored.

Suggested Citation

  • Hansen, Peter G., 2022. "New formulations of ambiguous volatility with an application to optimal dynamic contracting," Journal of Economic Theory, Elsevier, vol. 199(C).
    • Handle: RePEc:eee:jetheo:v:199:y:2022:i:c:s0022053121000223
    DOI: 10.1016/j.jet.2021.105205
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    More about this item

    Keywords

    Ambiguity; Stochastic volatility; Moral hazard; Capital structure; Asset pricing;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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